This chapter deals with inflation--its costs, causes, and cures. It emphasizes that inflation, a long-run phenomenon, is caused by high money supply growth rates.

In discussing the various measures of inflation, considerable space is devoted to the consumer price index because of its importance and the attention paid to it by the news media.

Considerable space is also devoted to the effects of inflation because of their importance and subtlety. (The costs of inflation are less obvious than those of unemployment.)

Attention is also paid to the money supply and the Federal Reserve. The appendix to this chapter elaborates on the money supply process and the means by which the Federal Reserve can alter the money supply.

The causes of inflation are examined within the quantity theory and aggregate supply-aggregate demand contexts. The conclusion is that inflation is a monetary phenomenon. It is emphasized, however, that both the income velocity of money and the output growth rate vary in the short run. Consequently, the relationship between the inflation and money supply growth rates is weaker in the short run than in the long run.

Although it is argued that inflation is a monetary phenomenon, the claim that firms and labor unions cause inflation is outlined and critically evaluated.

Various policy alternatives--monetary, fiscal, supply-side, and incomes--are considered as a means to reduce or eliminate inflation.

Instructional Objectives

After completing this chapter, your students should know:

1. How inflation is defined and measured.

2. That the consumer price index has a number of limitations as a measure of the cost of living.

3. That it is important to distinguish between unanticipated and anticipated inflation.

4. That inflation affects the economy in many different ways.

5. How the money supply is defined and that the Federal Reserve controls the nation's money supply.

6. How to explain inflation in terms of the quantity theory and aggregate supply-aggregate demand frameworks.

7. That with the income velocity of money and output growth rates constant, the inflation rate is determined by the growth rate of the money supply.

8. That to reduce the inflation rate the growth rate of the money supply must be reduced.

9. That supply-side policies, even ff they are successful in raising the nation's output growth rate, are unlikely to significantly reduce the inflation rate.

10. That incomes policy has many shortcomings as a means to control inflation and that the experience of the United States with wage-price guidelines and controls has been very discouraging.

Terms from Previous Chapters

should review the terms in this section at the beginning of your discussion of the chapter.

capital stock (Chapter 11)

aggregate supply curve (Chapter 11)

GDP deflator (Chapter 11)

exports (Chapter 11)

imports (Chapter 11)

nominal GDP (Chapter 11)

aggregate demand curve (Chapter 11)

business cycles (Chapter 11)

monopoly (Chapter 4)

monetary policy (Chapter 11)

unemployment rate (Chapter 12)

fiscal policy (Chapter 11)

contractionary fiscal policy (Chapter 11)

Key Terms

These terms are introduced in this chapter:

inflation

deflation

consumer price index (CPI)

cost-of-living adjustment (COLA) clause

unanticipated inflation

anticipated inflation

indexing

creditor

debtor

hyperinflation

medium of exchange

money

currency (cash)

demand deposits

money supply

central bank

quantity theory of money

equation of exchange

income velocity of money

supply-side policies

incomes policy

Additional References

In addition to the references in the text, instructors may wish to read or assign one or more of the following: